Is everything old new again?

• Author: ELLIG, BRUCE R.
• Position: Executive compensation planning

When it comes to executive compensation, a review of the historical record of executive pay design can be helpful in crafting the right plan for your company.

NEW ECONOMY tech stock darling of Wall Street, having soared over 5000% the past several years, plummets, losing over two-thirds of its value in six months. A recent news item about an Internet company? No, this business column item appeared some 75 years ago -- and the company was General Motors.

The rapid run-up -- and subsequent fall -- of new economy" stock prices is not new. It is a cycle that has been repeated a number of times in this country this century. The buying frenzy the past several years of new economy stock was similar in some respect to "tulipmania" of the 17th century. As we know, many new economy companies have "lost their bloom" but are hopeful they are perennials returning to blossom again, not annuals that perish at the end of the season. However, the message from the financial community is that the idea may be great but at some point there has to be a return on the investment for the investor. Unfortunately, many new economy companies have been more successful in selling their stock than in selling their product. The truly successful ones will someday get to be successful "old economy" companies.

Having said that about new economy stock price cycles, is the same true for stock plans designed by the current new economy companies? Is everything old new again? Yes and no. There have been a number of creative innovations in equity plans (predominantly in stock options) by new economy companies. However, it should be remembered that stock options themselves have been around for over 100 years. More about this later.

But first, let's review two areas that are key to the design of executive and key professional pay programs for new economy companies: market stage position, and importance of regulatory requirements. Each significantly shapes the type of pay plan one is likely to develop.

Market stage

As we know, a product is typically identified as being in one of four stages: threshold/developing, growth, maturity, and decline. The same description applies to companies.

The threshold stage itself has four parts: startup (an idea takes commercial form while the developers live off their credit cards and hope the huge stock option grants will have significant future value); development (venture capitalists provide money for salaries, as well as scale-up and marketing of the product/service); initial public offering (a rapid run-up of stock prices as the company successfully sells its stock); and post-IPO (stock prices settle back but hopefully provide sufficient gains for the founders and other key employees; revenue and market share gains are still more important than profits).

The differences between new economy and old economy pay models are inherent in terms of a company and industry market life cycle as shown in Table 1.

New economy companies are typically in the threshold and early stage of growth cycles. Old economy companies are in the latter stages of growth and maturity. New economy companies that have enjoyed the profitable growth stage for some years will discover their profits will start to look like old economy companies. There is little doubt that successful new economy companies (i.e., those that make it well into the growth stage) will undergo a transition to a more balanced pay program for the simple reason that they can afford it and, more importantly, stock options will no longer be able to generate the growth of earlier years.

As a result of the importance of the five pay elements by stage in the market cycle, the portion of pay attributed to each for the CEO also changes, with stock options moving from accounting for 90% or more of pay value to virtually nothing because of a dramatic flattening of the rate of appreciation in stock prices. This is illustrated in Table 2.

The regulators

In looking back over the 20th century, there were essentially four periods with varying importance on executive pay design by the regulators (namely, the IRS, SEC, and FASB):

1900-1912 -- Virtually regulation free. They truly were the "good old days."

1913-1933 -- Widely fluctuating maximum personal tax rates (after their 1913 introduction) made tax effectiveness very important in plan design.

1934-1972 -- Securities and Exchange Commission requirements on company stock were added to the tax issues and, coupled with on-again/off-again pay controls, created a three-legged stool of regulatory oversight.

1972-Present -- The emergence of accounting rules through APB and FASB on stock plans is a dominant feature overshadowing the IRS and SEC, bringing an Orwellian Animal Farm definition to the importance of the three.

Taxation (IRS)

The basic rule is that compensation is taxed as ordinary income and the company has a tax deduction for the same amount in the same year. The major exception is capital gains for which the company has no tax deduction.

Except for the first 12 years of the century, the country has had a personal income tax every year. The tax started out modestly: a progressive tax beginning at 1% and ending at 6% for all income in excess of $500,000. It was only about four years until that jumped to a top rate of 77% in order to help pay for World War I expenses. Since then tax rates have fluctuated, going up in bad times (the Depression and World War II) and shrinking...